Exchange-traded funds (ETFs) in Europe have recently shown spread improvements increasingly better than their underlying assets – a condition which seems to be boosting the instruments’ popularity among traders, according to new research.
Victor Lin, an analyst at Credit Suisse, said while average spreads were around 18 basis points (bps) in Europe compared to 5bps in the US, spreads nonetheless seemed to be coming down at a faster rate in Europe.
Narrower ETF spreads, in an equities market environment with uncharacteristically low liquidity, has compelled investors look more closely at using ETFs to gain exposure to otherwise hard-to-come-by assets.
“There are ETFs in Europe that trade with much tighter spreads than you could achieve if you traded the underlying basket,” said Lin. “We’re seeing ETFs offer the chance to improve upon spread costs compared to the underlying, for instance with a basket that’s less liquid like small cap or emerging market stocks.”
While lower spreads lead to cheaper trading costs, and spreads are generally more indicative of top of book/small trade sizes, Lin said a better indication of cost to trade was how the spread compared with the ETF’s underlyings. He said ETFs with tighter spreads than the component stocks often will result in cheaper executions for trades of the same size.
To examine such data, Lin said buy-siders were increasingly looking towards broker tools which offer a better understand ETFs and break down the costs of a trade.
“A lot of people just don’t know how ETFs work in terms of how efficient they are and how the underlying baskets interact with the actual ETF,” Lin said. “The actual costs of trading in and out of an ETF are driven in large part by the underlying; therefore, even though ETFs with similar underlying may have very different on-screen volumes, they should have comparable trading costs.”
Some industry players believe that until now, the opacity of the instruments has dampened ETF volumes in Europe, with most transactions traditionally OTC and unreported – a state which new European-wide regulation is set to address.
“There’s currently no uniform set of rules to record OTC ETF trading but MiFID II will focus on that obligation, so there is a hope this new regulation will require OTC trades to be reported,” said Lin. “We believe ETF trading will benefit from this, as liquidity will be posted on-exchange and the addition of a consolidated tape could bring that liquidity together under one ticker.”
The US market has surged over the last seven years, but European ETF trading has been slow to catch on, with trading volumes only now meeting US figures from 2005.
“If you follow the US ETF market, the fact that many ETFs trade with tighter spreads than their underlying is not surprising, but it’s good to see that the same is becoming more prevalent in Europe as well, which bodes well for people that want to trade more often,” Lin said.
Lin’s research also points out the effects market fragmentation has on ETF trading in Europe – with the same or similar instruments trading on multiple venues – and the desire for a consolidated tape.
“Sometimes spreads for similar products appear to be substantially different from one country to the next. However, instead of multiple ETFs with the same underlying that have fragmented liquidity across different exchanges, having a consolidated tape could help to show people that spreads are fairly tight and volumes are not as small as they currently appear,” Lin said.